While governments are galvanising activity to help tackle climate change, there are increasing concerns being raised around corporate greenwashing and the reliability of ESG-related data.
As well as this in recent weeks we have seen the very public resignation of Stuart Kirk – HSBC’s head of responsible investing – after he said he believed the financial impact of climate change had been “over-egged”.
ESG has also been the centre of controversy after Elon Musk’s tweet in May described ESG as “a scam” that had “been weaponized by phony social justice warriors,” when electronic-vehicle maker Tesla was removed from the S&P 500’s ESG Index.
In this environment, it can be difficult to ascertain if ESG is of real value or if it is solely a reputation management activity. Given the diverse and broad range of influences on what ESG involves for different sectors, as well as the breadth and diversity of stakeholder ESG expectations, it can be difficult to understand the importance and role ESG has to play.
The financial sector is under increased scrutiny to manage ESG. But what does this mean? Is ESG only carbon emissions management? Is it simply an exercise to appease activists? How can Private Equity (PE) and Venture Capitalist (VC) organisations best identify ESG risks and opportunities, which are essential at the firm, fund and investment levels?
Not everything can be quantified financially
Some of the concerns around ESG are due to difficulties in evaluating its impact on investment returns. While carbon taxes can be easily quantified by comparing the cost of carbon taxes now versus the expected cost in the future, and the cost of waste disposal is easy to calculate, other ESG issues are harder to quantify in financial terms.
For example, employee well-being and satisfaction cannot be quantified easily – but happy, healthy, efficient and productive employees can only have a positive impact on financial returns.
The fact is that corporate reputation, while it should never be the sole reason for ESG, still has a significant impact despite the fact it is hard to measure in financial terms. And yet, at the same time we are finding shareholders, employees and even governments raising concern at the lack of data and transparency relating to investment funds which are professed to be made on sustainable investment principles.
Some have suggested that Elon Musk has misunderstood ESG because he has focused on the environmental without considering the social issues and governance aspects to ESG such as diversity and inclusion, and these conversations are undoubtedly complicated by the fact that there is no one universal definition of ESG. ESG can mean different things and can be dependent on the sector you work in – ESG will be different for the technology sector than for the energy sector, for example.
There is also often a misunderstanding around the scope of ESG within an organisation. For instance, health and safety requirements fall under ESG, as do employee well-being schemes, as well as modern slavery supply chain protections.
Companies are in fact already engaging with ESG due to regulatory requirements. But there is a spectrum as to how far ESG is intrinsic to or integrated within a firm’s overall corporate objectives or values.
Investor concerns focus on ESG
Increasing regulatory and investor pressures are seeing further demand for private equity firms and venture capitalists to communicate ESG performance and demonstrate progression.
ESG is an inherent part of an organisation’s risk management approach. Identifying and mitigating material risks is a key part of an organisation’s success. To ensure future profitability and to ensure investors continue to be confident in the sustainability of their investments, ESG risks and opportunities must be managed.
In the past it was thought that to invest responsibly with an ESG emphasis meant sacrificing returns on investment assets.
But that is an old-fashioned way of thinking about it.
Investors still have expectations in that they want higher returns than the market rate. But it’s no longer viewed as either or in terms of profit or good ESG performance.
Investors are becoming more vocal about how they want their money to be used. Limited partners will state they have net zero requirements or say that they want the private equity firm to invest more in diversity and inclusion programmes.
In February, ITPEnergised released its second annual ESG Transparency: A Private Equity and Venture Capital Index to help highlight the firms leading the way on ESG and sharing what they disclose about their commitment to ESG and performance. The index offers an independent view and showcases current best practice for investors and those in the private equity and venture capitalist sector. It also highlights key insights into what is required to develop a robust ESG strategy.
It reveals those private equity firms and venture capitalists who view ESG as more than just a ‘nice to have’ and instead see ESG as a key pillar in their business strategy.
What do private equity firms and venture capitalists need to do to create a robust ESG framework
Many firms will already have exclusion lists that mandate what they will not invest in, such as tobacco or oil companies. And they may have ways of doing ESG due diligence before purchasing an asset, such as requiring that the company or asset increases certain aspects of their ESG performance.
What is important to investors and limited partners when it comes to ESG really must underpin any sort of ESG strategy.
There are internationally recognised ESG frameworks that can be helpful tools in identifying the key areas of ESG that a firm needs to focus on. But disclosure and transparency must be at the heart of this and ESG needs to be fully integrated into all investment decisions.
This article was written by Katie Jeffery, Associate at ITPEnergised, and appeared in Sustainable Investment on 31 August 2022. Please contact Katie at email@example.com if you would like more information or to discuss ESG.